Benefits of Small Cap Mutual Funds in India

High Potential Returns

Small cap mutual funds have the potential to generate higher returns in the long-run. This is due to their investment strategy. Small cap equity funds in India invest at least 65% of their portfolio in equities of small cap companies. Although these companies are small, they have the potential to grow over the course of five to ten years and generate potential returns. Despite the high-risk associated with a small cap fund investment, these schemes may generate potential returns as the small cap companies grow. 

Long-Term Investment

Small cap mutual funds are considered a long-term investment option due to the nature of their portfolio. Small-cap companies are generally new in the market and may have specific niches. While they may be lower in value right now, over time, they have the potential to grow significantly. Moreover, these schemes are vulnerable to short-term volatility and may underperform temporarily during market downturns. By remaining invested for longer periods, investors can potentially ride out short-term volatility and allow the small cap companies some time to grow, thus potentially generating returns. 

Moreover, staying invested for longer allows investors to gain the benefits of compounding. Compounding means that returns get reinvested. Over time, investors may potentially gain significantly through compounding. 

Portfolio Diversification

While small-cap equity funds invest in only one market cap, they have a diversified portfolio across different sectors. Small-cap companies may belong to various sectors, including tech, IT, pharmaceuticals, banking, finance, healthcare, consumer goods and services, etc. Investment in various sectors allows investors to spread their investments out, potentially reducing risk. If any one sector is significantly impacted by market downturns, the presence of stocks from another sector can help offset the underperformance. Nevertheless, small cap funds should be a part of an already diversified portfolio as they are a high-risk investment.

Relatively Lower NAV

Another key benefit of small cap funds is their Net Asset Value (NAV), which is generally lower. This means that investors can buy more units, especially during market downturns. When the market recovers, the returns from the small-cap fund may potentially be boosted. 

Learn more about what NAV is in mutual funds.

Active Fund Management

Small cap mutual funds are generally actively managed. This means that the stock selection is done with a specific strategy in mind to potentially outperform the market. Active fund management allows investors to benefit from expert research and analysis. 

Learn more about active vs passive mutual funds in India.

Small Cap Index Funds

Some investors may prefer a passive investment strategy wherein an index is passively tracked. Index schemes are a passive investment option that aim to track an underlying index and potentially replicate its returns. Small cap index mutual funds include the Nifty Small Cap 250 Index Fund, Nifty Small-Cap 100 Index Fund, etc. The expense ratio of these small cap funds is generally lower due to the lower management costs associated with them. However, they may be subject to tracking errors and be subject to other risks that could potentially be mitigated through active management. 

Exposure to New Businesses 

Investment in a small cap equity fund allows investors to gain exposure to new businesses entering the market. Small cap companies are often in early stages of growth and may operate in niche markets that have the potential to grow over a few years. By investing in small cap mutual funds, investors can gain access to these new opportunities early and potentially create substantial returns. 

Option for SIP and lumpsum

Investors have the option to invest in small cap funds through SIPs or lumpsum. SIPs allow investors to make small, periodic investments, whereas through lumpsum, investors can invest a big amount in one go. Both investment methods have certain pros and cons. SIPs may be suitable for investors who have a regular income and want to invest periodically, while lumpsum may be suitable for investors who have a big sum of money.

Small cap mutual funds in India offer investors an opportunity to participate in the growth of emerging companies with strong long-term potential. Although these funds carry higher risk due to market volatility, limited liquidity and the relatively smaller size of underlying businesses, they can play a role in long-term wealth creation. Benefits such as high returns, portfolio diversification across sectors, active fund management and exposure to new and niche businesses make small-cap funds a potentially attractive option for investors with a high-risk appetite. Additionally, the availability of SIP or lumpsum allows investors to align their strategy with their financial goals and income patterns. However, given the risks, small cap funds are generally suited as a part of a diversified portfolio and for investors who are willing to remain invested for a longer time to potentially benefit from growth and compounding.